Does the 3.8% Medicare Tax Impact Real Estate?

By Dr. Mark Lee Levine

As a result of the Healthcare and Education Reconciliation Act of 2010, passed in March, 2010, Code §1411 was placed in the tax law to generate what is referred to as a “3.8% Medicare tax,” which impacts general earnings as well as investments.

Under this provision, there is a Medicare tax that is 3.8%. (This is an increase from the prior 2.9% that had existed as to earned income for self-employed individuals.)

In addition to increasing the rate, the tax will now cover, starting in 2013, earned income via wages, etc., as well as investment income.

Actually 2.9% applies to wages, as noted. The 2.9% is double the 1.45%. (The 1.45% applies to the share that an employee pays of this tax; and, the employer pays the other 1.45%.)

The rate of 3.8%, as noted, applies to wages as well as investment income in the form of dividends, interest, certain capital gains and other types of non-earned income.

The tax is 3.8% multiplied against the lesser of:

a. Net investment income for the tax year in question; or

b. What is referred to as a Modified Adjusted Gross Income that exceeds a threshold amount.

The threshold amount is generally $250,000 for a married couple filing a joint return. If married couples file separate returns, the $250,000 noted results in $125,000 threshold for each of the parties. The threshold is $200,000 for single individuals.

Some items or earnings are not included within the taxable amount for the “net investment income.” As noted, the net investment income can include interest, dividends, and other earnings, such as capital gains. (However, capital gains are excluded to the extent that the amount of capital gain was generated under Code §121, the exclusion rule for gain on the sale of the principal residence. The amount of exclusion from net investment income would be the amount excluded for the principal residence rule, which exclusion is generally $500,000 for married couples filing jointly, and $250,000 for the single individual.)

Other items that might be excluded from this 3.8% tax include the items noted above, as well as certain other earnings, such as qualified distributions from retirement plans, certain tax-exempt interest, etc. See Code §1411, noted above.

The amount of the tax rate of 3.8% is levied against the Modified Adjusted Gross Income or the investment income, the lesser of the two.

Therefore, as an example, if a married couple had a net investment income of $100,000, and the couple also had Modified Adjusted Gross Income of $400,000, the excess of the Modified Adjusted Gross Income ($400,000) over the $250,000 amount, is $150,000. However, the $100,000 of net investment income is the lesser of the two.

Therefore, the tax would be $100,000 (x) 3.8% or a total of $3,800 of additional tax owing.

For more in this area, see new Code §1411, as mentioned. One key point to remember for purposes of the real estate area is that this tax does not include rental income, within the category of net investment income, if the taxpayer is not in a passive activity. For example, if the taxpayer is actively undertaking the business of real estate, property management, etc., of his or her properties, it is not a passive nature for the taxpayer; this income is not included within the rental income calculation of net investment income, as noted.